Each year, our Investment Team conducts a thorough review of our capital market assumptions (CMAs) across various asset classes. These CMAs form the bedrock of our portfolio construction process, forecasting the future performance of asset classes such as stocks, bonds, real estate, and alternative investments. By analysing projected returns, risk, and correlation data from multiple third-party sources and our internal estimates, we establish a consensus view for each asset class over 10-year and 30-year horizons. This data is instrumental in approximating the efficient frontier and assessing the trade-offs between different investment allocations.
2024 Update: Key Findings
Our 2024 CMA update indicates a notable shift in the risk-return trade-off. With rising interest rates and inflation, bond yields have increased, enhancing fixed income returns. Concurrently, equity markets have rebounded from the 2022 bear market and continued their long-term growth since 2009. These trends have compressed bond prices and elevated large cap equity valuations. Consequently, higher expected bond returns and lower expected stock returns have flattened the efficient frontier, reducing the reward for taking on additional risk.
Equities
U.S. large caps appear overvalued relative to historical standards, particularly among the “Magnificent 7” tech giants, which now constitute over 30% of the S&P 500 index. This concentration is driven by the rapid growth fuelled by generative AI. The sustainability of this momentum and the lofty market expectations for these stocks are in question. Already, some top performers like Tesla and Apple have underperformed in early 2024 after exceptional 2023 returns.
Given these valuations, we advise against chasing recent returns and recommend exploring small/mid-cap and international developed markets for more attractive entry points. The elevated valuations in large caps have also narrowed the return premium for equity risk. For example, the anticipated return advantage of an aggressive 80/20 stock/bond portfolio over a 55/45 mix has decreased from 0.74% to 0.37%.
Fixed Income
Within fixed income, higher interest rates have improved prospects for core fixed income, but municipal bonds now appear overvalued based on record-low Muni/Treasury yield ratios. Historically, high M/T ratios made municipal bonds valuable for tax-paying investors, but this is no longer universally true. Individual circumstances vary, but flexible allocations favoring taxable bonds may offer better after-tax outcomes depending on the investor’s tax rate. This highlights the importance of financial planning and maximizing after-tax returns in our wealth management process.
Alternatives
Alternative assets like private equity, real estate, and credit have shown more stability compared to public markets. It’s important to recognize that the perceived stability in private markets often results from less transparent pricing rather than lower risk. However, with some alternative asset classes expected to deliver equity-like returns of 7-8% and provide diversification benefits, investors willing to accept illiquidity risks may benefit over the long term.
Cash
Elevated yields have reinstated cash and short-term fixed income as viable options for generating returns above inflation. As inflation moderates towards the Fed’s target range, cash portfolios present an opportunity to preserve purchasing power while maintaining a defensive position. However, investors should avoid overextending into cash due to its limited long-term growth potential.
Looking Ahead
Our 2024 CMAs suggest a more modest return profile for traditional stock/bond portfolios. Nonetheless, the resurgence of cash and fixed income as return drivers offers investors a broader array of tools for portfolio construction. We emphasize the importance of diversifying asset classes and pursuing opportunistic investments across public and private markets to navigate this environment effectively. Our commitment remains to build well-constructed, risk-aligned portfolios tailored to each client’s unique situation and long-term goals.
Picture Cred: First Business Bank
